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Property Insurance Captives—A Funding Primer

It is a little known fact that property risks represent a significant amount of the world's captive premiums. Years ago, we thought that because property risk has no tail, i.e., a payout pattern spread out over a number of years subsequent to the loss, it wasn't suitable for a captive.

Captives, we were taught, required casualty lines, such as workers compensation
and general liability, because these lines tend to have long tails, thus allowing
the captive to spread out its loss payments while earning investment income
on the reserves. These days, however, we fancy ourselves to be more enlightened
and open-minded about that which does and does not belong in a captive.

Just to set the record straight, there is no risk that cannot be insured
in a captive. However, there are plenty of risks that
do not belong in a captive, but that's a
topic for another article. Let's consider the nature of property risk. First,
it has no significant tail. Unless the loss is something like 9/11, which has
drawn out for many years, property losses usually occur, are reported, and settle
in the same policy year.

The beauty of property risk is that once the policy year is over, it's really
over—property losses of any significant magnitude do not lay in wait, ready
to spring on the unsuspecting policyholder years after they occur, as do workers
compensation losses. As such, property risk has no incurred but not reported
losses (IBNR) to speak of. Instead of a tail, property risk has what we prosaically
refer to as a "nose," meaning that all of the risk lies in the future, stretched
out before the insured for infinity (or longer). A little joke here ... very
little.

The IRS Rules

So, without the threat of a prior-year loss sneaking up and wiping out the
captive's assets, and for every year that losses are minimal or manageable,
the captive can build surplus. Or can it? Just when we thought it was safe to
go back into the water, that pesky Internal Revenue Service (IRS) has to spoil
our party. Captives under the IRS's jurisdiction—all domestic and all offshore
captives that have elected to be taxed as if they were domestic companies—cannot
establish IBNR reserves for property losses in years for which no loss occurred.
As such, the premiums fall immediately to earnings and are taxed as such. A
simple example will illustrate.

Let's say that our captive has been receiving property insurance premiums
for 5 years, without a loss until the fifth year. The premiums for the first
4 years would be taxed as earnings, then, in year 5, we have a large loss. At
that point, we can carry back losses and recoup taxes, but only for 2 years.
The net result is a fairly large tax bill.

There must be other reasons why anyone would place property risk into their
domestic captive, because accelerated tax deductions or smoothing out the effects
of large, infrequent losses aren't part of the deal. The reasons for placing
property into captives vary from allocating losses among a large number of subsidiaries,
to buy downs of large corporate deductibles so the risk of a large property
loss is transferred to the captive and not to the small, defenseless, subsidiaries.

Nondomestic captives, those of the controlled foreign and noncontrolled foreign
corporation varieties (CFCs and NCFCs), are not subject to the IRS rules. CFCs,
however, while not taxed directly by the IRS do not escape taxation—their U.S.
owners are taxed on their percentage of captive ownership at their corporate
rates. NCFCs are entirely free of IRS regulation; until, that is, the U.S. insured
repatriates its funds. At that point, the funds are subject to taxation.

Funding the Captive

There are two basic ways in which a captive can structure its funding. Below
I discuss the structured and projected loss approaches.

The Structured Approach

In this approach, an aggregate limit of liability is decided upon—for example,
$20 million. In some form, the parent would fund $20 million into the captive.
The funding would be categorized into three components: premium, capital, and
collateral. It would be what is termed a "fully funded" captive, meaning that
regardless of what happened loss-wise, the captive would have $20 million to
pay losses. Only the amount designated as the premium would be deductible from
the parent's taxes, assuming the captive satisfied the IRS tests. In a $20 million
deal, maybe $1 million is designated to be the premium, the next $18 million
or so as collateral backed by a letter of credit (LOC), and the remainder as
capital, usually a combination of cash and LOCs. Subsequent year premium funding
would be in response to losses reducing the total amount, in this example, $20
million. Expenses are in addition to the $20 million funding.

The Projected Losses Approach

Here, the funding is composed of a projection of losses based on the loss
limit (which comprises the premium) and an amount of capital necessary to support
the premium, usually one-third, giving us a 3:1 premium-to-capital and surplus
solvency ratio. For example, assume that losses within the parent's current
deductible covering $20 million (loss limit) of property can be projected to
be between $500,000 and $1 million annually. In property, projected losses are
derived from the COPE characteristics (construction, occupancy, protection,
and exposures) in concert with a PML (probable maximum loss) evaluation, or
some such variation of this, and geographic value concentrations.

The $20 million loss limit is usually not the total amount of property at
risk; it's often the portion that, under the most extreme loss scenario, could
be susceptible to loss. (The loss limit could be the PML of a $500 million portfolio,
the total insurable value (TIV). While the loss limit is no more than $20 million,
the rate, however, is based on the TIV of the portfolio, and not the loss limit.

So, in the first year, the captive would have total assets of about $1.3
million (a $1 million premium plus $300,000 of capital). There are a number
of ways in which to cover the limit above the captive's funding up to the total
amount at risk ($20 million). The captive could buy reinsurance for $19 million
excess $1 million, or, it could purchase reinsurance excess of a corridor deductible,
which is excess of the captive's $1 million funding. For example, the corridor
deductible might be $9 million xs $1 million; it's an unfunded, unsecured deductible
assumed by the captive's parent. With a parent's strong balance sheet, reinsurance
for $10 million xs $10 million would be available and not very expensive. Sometimes
the reinsurer will require that the corridor deductible be secured by a letter
of credit to reduce the premium, or agree to assume the reinsurance in the first
place.

It's important to remember that all of the decisions made in the projected
loss approach are, unlike in the structured approach, based on loss probabilities.
The projected loss approach is almost identical to how large multiline commercial
insurers set rates and determine per-risk capacity. This brings us to a question:
How big must the property portfolio be to be insured in a captive? The answer
isn't so much based on size as it is on geographic diversity. Large, highly
diverse property portfolios mimic the conditions required by commercial property
insurers, namely, the law of large numbers; the premiums of the many pay the
losses of the few. Remember this, and you'll always have a ready answer to the
ubiquitous cocktail party question … how exactly does insurance work, anyway?

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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